What Do Morningstar Analysts Look for in a Fund?

Most investors reading this will be familiar with the Morningstar quantitative star rating. But the star rating does not tell the whole story......

Tom Whitelaw 07.04.2008
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Most investors reading this will be familiar with the Morningstar quantitative star rating. But the star rating does not tell the whole story; it is purely based on risk-adjusted past performance and as such has clear limitations. As with any investment, you need to understand what drove past performance, and how those factors might affect a fund in the future. That's why we have built a team of qualitative fund analysts here and why qualitative fund analysis has been the heart of Morningstar for more than 20 years.

Our analysts are often asked what they look for in a fund. There is no one easy answer, but there are very clear qualities that we want to see in a fund and in the management organisation that run

s it. Well discuss some of the most important ones below, and will continue the theme in tomorrow's column.

The Organisation
Funds are not run in isolation. You can find an offering with best manager in the world, but if the fund house doesn't do what it takes to retain him, he may leave before you have much of a chance to benefit. Further, the corporate culture at a fund company can tell you a lot about its strengths and weaknesses. Asset management is a business and all fund companies aim to grow their profits at a good clip. However, some firms try to do this responsibly--delivering good value to investors by running funds in areas where they can deliver strong long-term performance. Others try to gather assets quickly by rolling out new funds in areas where there's a lot of interest and marketing them heavily. We greatly prefer the former--the latter tend to have little staying power and often burn investors who buy in near the peak of a trend.

More generally, we find that firms that run into problems are often those where the marketing side of the group has a bigger voice in fund creation and management than the investment group. Put simply, when pushing product becomes more important than responsibly stewarding assets, it's often a recipe for disaster. Other key items we evaluate include how the firm's management works to keep costs down to investors (if it does so at all) how they evaluate capacity at their funds and if they do a good job of closing funds that are in danger of growing too large. Ignoring costs or capacity is a dangerous sign and often a flag that a firm is more interested in lining its own pockets than in doing the right thing for fund investors.

The Fund Manager and Team
Assuming the organisation is sound, at the end of the day the buck stops with the fund manager. We consider his experience, track record and philosophy, and we look to see if he has run similar funds in the past (this is especially relevant if his track record at a current fund is limited), and how he fared there. We also look at the fund company's research resources, including the depth and stability of the fund management team, the number of analysts at the manager’s disposal, their experience and the extent of their stock and sector coverage responsibilities. To put some perspective on the matter, our own equity analysts, who undertake in depth modelling of firms' cash flows through time, can usually effectively research between 20 and 30 stocks on an ongoing basis. A manager or analyst relying heavily on outside research can cover many more, but may also simply be getting the same ideas City brokers are pushing to everyone else. Finally, we look at the manager's other responsibilities (such as helping to market the fund) that may detract from the time he is able to spend with his portfolio.

Investment Process and Style
A fund manager's style and process can often be dictated by the group that he works for, so we want to make sure that the two fit together well – after all a fund manager who is used to working with a large global analyst group, such as that provided by Newton, may find it difficult to adapt to somewhere like New Star, who have more of a star manager culture. And a small-cap manager may have a hard time making much use of the analyst staff at a shop that is otherwise focused on large-cap research. We thus consider the fund's investment process, including stock screening, portfolio construction, sector allocation and risk management, making sure that the philosophy of the fund fits with that of the fund management group and manager. We also look at whether or not the manager has stayed true to his stated style, or if there has been a drift, for example, away from value stocks towards those with a growthier bent. We have no interest in policing a fund's style (unless it claims to be a style-specific fund), but we do want to know where it has been, where' it's likely to go, and why.

Portfolio Construction and Risk Controls
Once we get to grips with a manager's process and style we look at how he goes about constructing his portfolio. Most groups will provide their managers with portfolio constraints in order to manage risk. So we look for any stock, sector, geographic, market-cap or liquidity constraints outside of those imposed by the FSA that may affect the fund's management. The fund's concentration in individual issues is also of interest. It's an obvious indicator of risk, but it can also tell you other things. For example if the fund started its life with 35 holdings, but has seen this number climb to 70 as assets have grown, it may indicate that the manager is running too much money and is being forced to buy his "B" team rather than stick with his best ideas.

Stock Selection
Morningstar analysts spend considerable time studying a fund's complete holdings--both as they stand currently, and as they've evolved through time. The portfolio's holdings tell us about the fundamental risks inherent in the portfolio --if the manager is investing in heavily indebted companies, for example, it could find itself in trouble in a recession. More broadly, a review of the holdings tells us if the manager is sticking to his strategy, and how that strategy changes in response to shifting market conditions. For example if a manager has a strong track record investing in larger cap stocks suddenly starts moving down the cap ladder into smaller companies, where information is much more difficult to come across, it's worth asking why - especially if the manager operates on his own and has previously been heavily reliant on broker research which is far sparser at this level. Or, if a manager claims to have a strong valuation discipline, but richly valued shares appears in the portfolio, we'll want an explanation. We also focus on how the manager's buy and sell disciplines play out with regard to specific holdings. Of particular interest are where managers' have opposed consensus views to good effect, or have made mistakes but learned from them.

A fund manager's incentive pay can be multiples of his base salary. As such, it has a strong impact on how he runs the fund. If a fund manager's bonus is tied to his short term performance he may well be more reckless and take on more risk because he wants to maximise his near-term pay out – after all at the end of the year the slate is wiped clean. We therefore prefer to see managers who are incentivised over the longer term thus providing performance goals that are more closely aligned with the time horizons of investors. It's even better if the awards vest over time, as this provides additional incentive for good managers to stick around. However, if an incentive scheme is heavily weighted towards asset growth or profitability of the fund manager, that's a potential cause for concern--such measures can encourage managers to grow funds beyond their optimal size (a big concern in the small- and mid-cap arenas) or to keep expenses at a high level.

We also want to see managers invest in their own funds: If they are not willing to risk their own money, one has to question why others would. Some of the best shops we know pay bonuses in fund shares that vest over time, but this is sadly unusual.

Charges are a vital part of any fund assessment. Many factors can impact fund performance, but expenses eat away at the value of your investment year after year after year, and the effect compounds with time. Unfortunately in the UK there has been very little pressure on the competitive pricing of investment funds, but the effects over the life of an investment can be quite staggering – for example take the Fidelity Moneybuilder UK Index fund. It has a TER of 0.28%, which compares favourably the Nationwide Tracker which levies a TER of 1.5% to follow the same benchmark. If you invested £10,000 into both of these funds, and assumed an annual return of ten percent, your investment in the Nationwide fund would be worth £2,888 less after ten years (that's the equivalent of an additional 28.88% cumulative return on your original investment that you would miss out on!). Among active funds, the more expensive the offering, the more outperformance a manager has to deliver just to break even with his benchmark. Studies we have run elsewhere suggest that managers of higher cost fixed-interest funds systematically take on more risk than their lower-cost rivals in an effort to make up for this disadvantage.

Judging a fund by its performance alone can be a recipe for disaster, but patterns in a fund's long term performance can be a helpful way to see if a fund is behaving as we expect given the manager's stated strategy. We not only consider the portfolio's benchmark, but more importantly the Morningstar category into which the fund falls – this helps give a fairer reflection of how the fund has performed compared to similar offerings that investors can buy. For example, if a fund claims to only buy companies with strong cash flows, but did well in TMT-led 1999 and got clobbered in the ensuing meltdown, it would suggest that manager deviated substantially from that discipline.

Short term performance is often meaningless, so ideally we like to see a strong longer term (5 years +) track record, that has been achieved with below average volatility, but again, it's important to judge that record in the right context. There are plenty of large-cap managers who are very good at what they do, but who have looked poor versus the larger universe of UK equity funds during the mid-cap rally of the last five years. That's not a fair or useful comparison. Just as it makes no sense for a mid-cap manager to be given credit for beating a FTSE 100 fund, we wouldn't dismiss larger-cap funds that fail to beat an all-cap benchmark or peer group.

Readers will note that performance comes only at the end of this two part series. Although it merits attention, investing based purely on past performance--especially short-term performance--is a fool's errand. In our experience, it leads investors to purchase funds when their style or strategy is peaking and ready for a downturn and to sell funds just as they might be ready to rebound (i.e., buy high and sell low). Moreover, it really is a poor predictor of future results. So use it as a starting point, but focus on long-term, risk-adjusted performance, and follow up with an investigation of the other fundamental factors we discussed above. If you do that, and if you remember that the goal is not to select the hottest fund today, but those that will help you reach your investment goals over time with the least amount of risk--in the context of your overall portfolio--we think you'll ultimately have far more success.

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Tom Whitelaw  

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